Monday, July 12, 2010

An econ prof explains why macro went down the tubes

I've often ranted about the "neoclassical revolution" in macroeconomics, which came along in the late 70s and early 80s and turned macro into a cargo cult (or what Krugman calls a "Dark Age"). I've generally implied, or said outright, that the reason people like Robert Lucas and Ed Prescott committed this dastardly deed was political - they wanted an intellectual justification for the rising tide of anti-government conservatism that was sweeping the nation. But rarely do you hear supporters of the neoclassical (or "Real Business Cycle") paradigm admit this openly. Which is why this blog post by Stephen Williamson of Washington University (the most "conservative" econ department after Chicago) is so refreshing:

In the Keynesian world, fluctuations in aggregate economic activity are inefficient, and the logic appeared to be consistent with what we observe. We find ourselves in the middle of a recession. In terms of the its basic fundamentals, the economy looks more or less the same as it did before the recession happened. There is roughly the same set of people, with the same skills. The same buildings and machines are in existence, and we know just as much about how to produce stuff as we did before the recession happened. However, we are producing less and more people are out of work. Surely something has gone wrong, and the government can do something about it, by spending more and relaxing monetary policy to put people back to work.

However, the Phelps volume writers and Lucas got us thinking about the following. An unemployed person is someone who answers the labor force survey in a particular way. This person is engaged in a particular activity – search – and we can analyze this process just as we would analyze anything else in economics, as involving choice and incentives. Due to a mismatch between the workers that firms want and the jobs that workers would like to have, separations due to various factors, and people moving in and out of the labor force, there will always be unemployment. Further, fluctuations in these factors determining unemployment will make the unemployment rate fluctuate. Indeed, we might imagine fluctuations in unemployment that are purely efficient – there may be nothing the government should do about this.

The part in bold illustrates the neoclassical concept of unemployment: it doesn't exist. Unemployed people are simply unwilling to take the jobs that are being offered to them. You can hear this idea in the speeches of many Republican politicians to this very day.

Next, along come Kydland and Prescott in 1982, with what later became known as real business cycle analysis...Kydland and Prescott were thinking outside the box, and they were very much in the faces of mainstream macroeconomists...[they] gave economists license to contemplate the possibility that business cycles could be bad events that we should do nothing about – government intervention could serve only to make the problem worse[.]

This is extremely telling. Usually, you hear economists say that Prescott's contribution was methodological; that he showed economists that they could make models using more sophisticated techniques than they had been using before, and that these new techniques allowed economists to take more things into account. What Williamson is saying is that, actually, Prescott's work was embraced because of its ideological contribution - it gave people "license" (i.e. an excuse) to say that government shouldn't try to do anything about recessions.

The economics of Kydland, Prescott, Lucas, Sargent, and Wallace looked more firmly grounded in the solid general equilibrium theory developed by Arrow and Debreu, and these people had good arguments which appeared to match well with empirical observations. Relative to this, mainstream Keynesian economics just looked mushy. Who would want to tie their caboose to that train?

The part about "matching empirical observations" aside (RBC models do not), what Williamson is saying is that the fancy math of RBC models was useful because it made Keynesian models look bad in comparison. Math was used as a signal of smarts, in order to get people to abandon Keynesianism.

Now, though Kydland and Prescott presented an extreme view of business cycles, which could be interpreted as telling us that the government is irrelevant...[t]he key lesson is that...[s]kepticism about the role of government is healthy[.]

Williamson is not directly saying that economics should be moral philosophy first and descriptive science second. But that is what his retelling of history amounts to. Models, in his view, should receive attention according to the moral stories that they tell. After all, anyone can write down a model that assumes that the government is powerless to change the economy; it didn't take Prescott's fancy math to do that. Williamson and other supporters of the RBC paradigm looked for the lesson they wanted to be taught.

(Of course, this is not exactly surprising, given that Prescott said just the other day that our current recession was caused by people predicting that Obama would be elected and raise their taxes! But it's one thing to expose Prescott as a crank, another to realize that a whole school of macroeconomic thought was embraced by thousands of economists for ideological reasons.)

This illustrates one of the basic problems with macroeconomics as a science - politics always gets involved. Good economic management inevitably has to compromise itself to the interests of various groups who are seeking to divide the pie to their liking; in the case of the RBC "revolution," the interest group in question was composed of rich individuals who wanted lower taxes and businesses who wanted lighter regulation. They wanted a theory that said government is bad, and they got it. In the short term, only the scientific credibility of macroeconomics suffered, but thirty years later, it's your job, your wages, your prospects, and your security that are suffering.

(Note: in the photo above. Prescott is the man smiling at the camera. The man shaking Bush's hand is Finn Kydland, his co-author on the original RBC paper - i.e. a Norwegian guy Prescott brought in to do all the math.)